Some Tech Start-Ups Struggle in Rising Tide of Fund-Raising

When Chad Etzel and Paul Stamatiou began to raise additional money for their technology start-up in the fall of 2010, they were preparing for an investment frenzy.

The young entrepreneurs, who had already raised $200,000 for Notifo, their mobile notifications platform for businesses, used their contacts from the start-up incubator Y Combinator, along with the investor matchmaking site AngelList, to arrange nearly 40 meetings with venture capitalists, including some of the best-known investors in Silicon Valley. They set a goal at $300,000, later increasing the number to $500,000.

But their second fund-raising drive was a flop. While Mr. Etzel and Mr. Stamatiou courted dozens of investors via Skype chats, conference calls and in-person meetings, they raised only a small fraction of the intended amount.

“The hardest part is not hearing back,” Mr. Stamatiou wrote of his investor meetings, in a blog post titled “Startup Fundraising is a Time Sink.” “They would say they would get in touch next week, but nothing ever came.”

In the midst of a social media boom that has flooded the technology sector with billions of dollars from wealthy individuals and venture capital firms looking for the next Facebook, Groupon or LinkedIn, companies like Notifo may seem like anomalies, unlucky losers in an age of easy money. But Mr. Etzel and Mr. Stamatiou aren’t alone. A rising tide in the tech start-up world has not lifted all boats, and some Silicon Valley entrepreneurs are struggling to keep their companies afloat.

Right now, the biggest trap in the start-up cycle are the so-called expansion rounds, investments of $5 million to $10 million that fledgling companies use to finance their growth. This stage, also referred to as Series B and C rounds, typically takes place 12 to 18 months after a company’s initial round, or “seed stage,” but before big-name backers like Kleiner Perkins Caufield & Byers and Sequoia Capital come on the scene.

This capital is critical to young companies that have exhausted most of their seed money but have yet to turn a significant profit. But investors are less willing to jump in at this point, looking instead for either brand-new ideas or proven companies.

“It’s easier than it used to be to raise seed capital, and it’s easier to raise growth-stage capital,” said Jeffrey J. Bussgang, a partner at the Boston-based venture firm Flybridge Capital Partners. “But there’s a chasm in the middle, and that chasm is growing.”

Venture capital firms financed only 211 expansion rounds last quarter, compared with 269 expansion rounds in the fourth quarter of 2010, according to a MoneyTree report released by PricewaterhouseCoopers and the National Venture Capital Association. In all, companies in this stage raised $1.9 billion last quarter versus $2.5 billion the previous quarter.

Not all entrepreneurs are having trouble raising capital at this stage. Jon Dahl, the founder of an online video encoding start-up, Zencoder, raised $2 million this year from well-known venture capital firms including Andreessen-Horowitz and Ignition Partners. Mr. Dahl, who also participated in Y Combinator in 2010, said that Zencoder’s most recent fund-raising round had been oversubscribed, meaning that the company had to turn away money.

Expansion rounds have always been a fairly high bar, Mr. Dahl said. “There could just be more people who are struggling with the high bar now.”

The situation may only get worse when hundreds of technology start-ups recently financed with early-stage investments begin looking for additional capital over the next two years. Adeo Ressi, founder of the venture capital reviewing site The Funded, has christened 2011 the Year of the Start-Up Default. He believes that the downturn in expansion-stage financing will hamper entrepreneurs’ ability to pay back the debt owed to their earlier seed-stage investors and force them to close up shop.

“There will be a washout in the later rounds,” said Pano Anthos, founder of a start-up consulting firm, Guided Launch. “Entrepreneurs think they’re set because they have their seed round, but a seed round is just a ticket to the dance.”

Mr. Anthos has experienced start-up failures first hand. His last tech company, a virtual world application called Hangout.net, was greeted with fanfare when it started in 2008, with some in Silicon Valley heralding the site as a potential successor to the online virtual world Second Life. But Hangout.net began to fizzle in 2009, following a burst of new competition that made it harder to woo investors.

“There’s 13 social commerce start-ups and 14 inbox-solution start-ups,” Mr. Anthos said of today’s crowded Internet venture space. “How many more of these can we have?”

Some see the dearth of expansion capital as a good thing, since it weeds out weaker, less viable companies. The process could help prevent the frenzied growth during the dot-com boom in the late 1990s, when hundreds of companies with no profits and undeveloped business models went public only to flame out later.

The fund-raising gap also has not dissuaded the legions of young programmers hoping to cash in on the current technology frenzy. Mr. Stamatiou, who declined to comment on Notifo’s woes, said in a phone interview that he planned to remain involved in start-ups.

But Mr. Bussgang of Flybridge Capital, who also teaches entrepreneurship at Harvard Business School, has been warning his students about the difficulties of raising money even in a generous investing climate.

“I tell them, this is a game of musical chairs. And at some point, the music’s going to stop.”